Barbarians at the Gate - Book Review

By Lorenzo Ayres

Authors: Bryan Burrough and John Helyar

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The story Barbarians at the Gate tells really starts six years before RJR Nabisco, with a greeting card company.

In 1982, a group led by William Simon, who had been U.S. Treasury Secretary, bought Gibson Greetings by putting up $1 million of equity against $79 million of borrowed money. Eighteen months later, they sold it for $290 million. Simon personally put in $330,000 and took out $66 million.

The authors call that moment the gold at Sutter's Mill, and everything that follows in the book is the rush that came after it.

That’s the sentence I'd put in front of anybody who thinks this is a story about cigarettes and greed in the eighties. It’s a story about what happens to an industry after one deal makes an unreasonable amount of money in public.

Yes, everybody has heard of this book, most of them have not read it, and the ones who did read it as a morality play. You should read it as a mechanics book instead, because the RJR Nabisco buyout is possibly the most thoroughly documented transaction in American business and Bryan Burrough and John Helyar were the two Wall Street Journal reporters who covered it live, Helyar down in Atlanta where the company was headquartered and Burrough in Brooklyn. HarperCollins put them together and gave two first-time authors eight months in 1989. The two never met in person until the day they signed the contract. Burrough's later summary of the whole business is worth more than most finance commentary: Wall Street produces a product that makes money, and then it gets overused, and by the wrong people.

The company itself wasn’t in trouble, which is the part people forget. RJR Nabisco was the 19th-largest corporation in the United States, $16 billion of revenue in 1987, real earnings, a smokeless cigarette called Premier that the authors say produced little but ridicule, and a stock that wouldn’t move out of the mid-$50s. Its CEO, F. Ross Johnson, had two personal maids on the company payroll, something like two dozen club memberships billed to the company, 10 corporate jets and 36pilots to fly them - which the people inside called the RJR air force - and millions going out to sports stars. Johnson’s own line about money, quoted in the book, is, “A few million dollars are lost in the sands of time.” That’s the man who decided the market was undervaluing his shares.

On October 20, 1988, Johnson's group proposed taking the company private at $75 a share, about $17 billion, backed by Shearson Lehman Hutton.

Understand what Shearson was at that moment. It was a firm that had never done a leveraged buyout and had no junk bond department, agreeing to lead the largest LBOever attempted. Peter Cohen at Shearson gave Johnson control of the company after the deal, a veto over his own firing, and a management stake structured so it could be worth up to $2.5 billion

Eight executives were putting in around $20 million of their own money for 8.5% of the equity, rising to 18.5%. Johnson's parachute was about $53 million. Henry Kravis at KKR read the $75 bid, correctly, as a lowball on a company the bidder knew from the inside.

Now here’s the ego math, and it’s the part of the book I return to again and again. Four days later, KKR came back at $90 a share, about $20.6 billion, and Kravis was not primarily doing arithmetic. He had discussed a buyout of RJR with Johnson earlier and felt excluded, Cohen was a Columbia classmate of his, and Time reported him saying to Cohen, “This is my franchise.” They tried a truce over breakfast at the Plaza. Two days of joint talks collapsed on control, because KKR would not do a deal it didn’t control and Shearson had already promised Johnson 51% of the votes. There’s an anecdote in the Time reporting from that week that George Roberts of KKR arrived at a quarter past one in the morning and asked Cohen sarcastically whether a company selling 290 billion cigarettes a year also made cigars, and then moved to the other side of the room. Time called it possibly the most expensive personal gaffe in the annals of corporate negotiations. KKR then reportedly offered Shearson $125 million s to step aside, which Cohen called personally insulting. So a $25 billion outcome moved on a cigar joke and a hurt feeling about a fee, and anybody who has sat in on a real negotiation knows that’s not an exaggeration, it’s just not usually written down.

The board then did the one intelligent thing in the entire story. A special committee of outside directors, chaired by Charles Hugel, took the process away from management, hired Lazard and Dillon Read as advisers and Skadden as counsel, and opened the auction to anyone who wanted in. At a dinner at the Waverly Hotel, one of the directors described their own chief executive as a raider from the inside. First Boston came in with the Pritzkers and a tax-driven installment sale structure worth as much as $118 a share, which forced the committee to reopen the bidding. Ted Forstmann entered and left, calling KKR's money “phoney junk bond crap” and saying, “We need to push the barbarians back from the city gates,” the origin of the title. And then the management group's side deal leaked, and the number everybody read about wasn’t the price of the company, it was how much Johnson stood to make from selling it.

The final round took place on November 29-30, 1988. Management, with Shearson and Salomon, bid $112 a share in cash and securities. KKR bid $109 The committee's own bankers told them the two were substantially equivalent. The board took the $109.

I was wrong about why they did so for years, and I want to correct myself publicly. I used to say Kravis was the one who understood that an auction is about certainty rather than price. But he wasn’t the one making that argument. Forstmann was, loudly, and Forstmann lost. What actually happened is that the committee judged the paper differently: a large part of management's $112 was securities whose value depended on the bonds being repriced to par later. KKR's financing, on the other hand, was already committed, and the leaked side deal had destroyed the board's trust in the management group. So the honest version is that the board bought certainty and the buyer who supplied it was the junk bond firm everybody in the room was calling the barbarian. Some people at the time argued the reset worry was a convenient reason for a board that had already decided it wanted rid of Johnson, and I think that’s probably partly true.

What followed the argument against the whole era, and the authors don’t pull their punches About $25 billion, $31 billion counting assumed debt, roughly 87% of it borrowed, with KKR and its investors putting up around $1.5 billion of actual cash and somewhere near $500 million going out in fees to bankers and lawyers. RJR's existing investment-grade bondholders lost more than $100 million overnight because the new debt sat on top of them, and MetLife sued and lost, since nothing in the indenture said the company couldn’t do this to them. The company lost over $1 billion in 1989 after $3.3 billion of debt service, and the reset provision had to be defused in 1990 with $1.7 billion of fresh KKR equity. Within a year of the close, 2,600 employees were gone and the price of a box of Ritz crackers was up about 30%. The authors' own verdict is that the investment bankers were part croupiers and part alchemists, and they imagine the founders of the two companies walking through the wreckage asking why these people were so intent on breaking up instead of building up.

I should say where my own reading of this book is wrong, or at least where I’m asking it to be something it’s not. Barbarians at the Gate is a book about people, not mechanics. The first third details F. Ross Johnson's career and the history of the junk bond; candidly, I found most of it boring. The hour-by-hour reporting only really starts when the auction does. Many readers complain that it rambles and that the cast is hard to keep straight, and they’re right. There are dozens of named bankers and I still mix two of them up, despite several rereads. Telling people to read it as a mechanics book is my instruction and not the authors'. And the deal that defines the genre made its own investors almost nothing, which cuts the legs off any reading of Kravis as the man who had it figured out. He won the auction. He did not win the deal.

What I actually use is the certainty point, and I use it constantly. I’m refinancing about $9.3 million across seven separate notes through the USDA and quoting $13 million, because the plan is the refinance plus anywhere between $2 and $3 million for the revamp, and I’ve personally guaranteed all of it twice. When two lenders are in front of me, the one quoting a lower rate subject to conditions isn’t offering a better deal than the one with a firm commitment at a slightly worse number, and the RJR board is the precedent for saying that out loud to my own people when they want to chase the cheaper quote. Same thing on the cabins at America’s Outdoor Adventure Park. A clean cash at close purchase at a lower headline price beats a higher number with seller financing or an earn-out hanging off it, because the higher number isn’t a number; it’s a range whose bounds are defined by someone else’s behavior, an inherently unknown and unknowable variable.

The leaked side deal is the piece I take most personally, because I’m on both sides of my own transactions. I operate the park and I sell individual cabins to investors, and there are versions of the future where I buy cabins back or take a promote on investor units. Johnson's package was not illegal and it was not unusual for its time, and it killed his bid because it got read out loud. So any structure where I’m both the operator and a buyer gets written as though it will be read aloud in a room full of my investors, because eventually it will be. The other half of that is MetLife: those bondholders had no protection because the protection wasn’t written in the document, and it didn’t matter at all what anybody had assumed or intended.

F. Ross Johnson walked away with about $53 million. KKR's limited partners, on the biggest leveraged buyout in history, earned under 1% a year by the time it was unwound in 2004.

About Lorenzo Ayres

Lorenzo Ayres is a business builder, dealmaker, and owner of America’s Outdoor Adventure Park in Jay, Oklahoma. Here he reviews books on investing, deal structure, and business strategy.

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